A Tale of Two Tails: Using Options to Forecast the Movement of Stocks

Stock markets failed to predict the current decline of the economy. In 2007, almost all the major indices were performing well. However, clearly something bad was about to occur. In this paper we shall show that by exploring the information contained in option prices one can find a different story. A key tool introduced in this paper is a new quantity which measures the Bullish or Bearish nature of the financial market and an option formula based on a new distribution. Combining these tools enables us to explore the potential power of option prices to predict movements of the underlying asset. Using option data from 2007 and from 12 major companies and the S & P 500 Index in the US financial market, our approach successfully forecasts the bearish behavior of these stocks in the year 2008. The result suggests that this new approach might provide useful predictions for the trend of the underlying asset.